China and US Stuck in 'Currency Trap'

Fears over default or restructuring by a euro-zone member like Greece or Portugal have been rife for months and are raising big concerns about losses on the balance sheets of banks in Europe and beyond.

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Chinese Yuan and US Dollar

But the problem for many bond fund managers is not default, or the risk of the default but a "currency trap," according to Tim Scala, a macro strategist at Sophis Investments in New York.

“Bond managers who never looked at the foreign exchange markets have had big trouble," Scala said in a research note.

"Many have lots of euro zone sovereign debts on their books and whilst confident they will be paid in full have found themselves facing big losses simply because the euro has fallen so sharply.”

Too many within the US have ignored the currency markets, Scala said, and with the world getting smaller and smaller investors need to pay more attention to foreign exchange.

“Volatile currency markets are likely to become a more prominent driving force behind major market moves," he said. "US markets have seen our markets increasingly impacted by events in Europe simply because of the way the global economies have been interconnected.”

China and Japan in the Currency Trap

This is exactly the position Chinese and Japanese investors find themselves in when holding US Treasurys, he said.

"While they may accept the credit risk and yield, the currency risk, while not an issue just now, could well determine whether it makes sense to buy any more or even hold the ones they already have," he added.

If the value of the dollar were to become suspect, for instance, due to additional quantitative easing by the Fed, the “Chinese and Japanese could easily decide that the yields no longer justify the risks” Scala said.

If this were to happen it would have huge implications for US bond and stocks markets, but could mean the Fed is in no position to further stimulate trade and the economy via a weak dollar policy.

“The fact that so many of our assets are held by foreigners means we can only hope that our elected officials reject this approach” Scala said.

Last week Bob Janjuah, the chief markets strategist and a bear at RBS, told CNBC he believed this is exactly what the US and its partners will do.

He said he believes with firms, individuals and ultimately governments set to cut back on spending growth will fall sharply across the world.

“Over the next 6 months we will see private sector deflation pushing 10 year yields down to 2 percent," Janjuah said. "This will see the policy makers mistakenly attempt to kick start the economy and market with a global quantitative easing program worth between $10 and $15 trillion dollars.”